What Is a Deferred Annuity -- and How Does It Work?

A deferred annuity is a contract between you and a life insurance company. Funds are exchanged for a promise to provide a competitive rate of interest with a minimum interest rate guarantee while guaranteeing the principal investment as well. The benefit payments don't start until perhaps 10 or 20 years down the road. The longer you wait for the payments to kick in, the more you'll get.

The downside is that if you don't make it to 85 or whatever age you select for payments to start, you get nothing. At the same time, benefits aren't inflation adjusted, so their purchasing power will have declined by the time you get the bucks.

But because the payments take place so far in the future, you can buy a bigger benefit. And because these annuities are classified as nonqualified retirement instruments, you receive a tax benefit: a tax deferral on earnings. Earnings are taxed as ordinary income when withdrawn.

Deferred annuities can come with all sorts of features:

Fixed deferred annuity – works like a certificate of deposit, but the interest is deferred until you take a withdrawal from the annuity contract. Upon purchase, you'll be told the guaranteed interest rate your funds will earn.

Variable deferred annuity – a lot like owning a group of mutual funds. In an annuity, they're called sub-accounts. You have control over the amount of investment risk by choosing from a pre-selected list of sub-accounts, including both bond and equity investments. Returns vary depending on the performance of the underlying sub-accounts.

Equity-indexed annuity – functions like a fixed annuity in some ways and like a variable annuity in other ways. Technically, it is a type of fixed annuity. Equity-indexed annuities have two components: a minimum guaranteed return and the possibility of earning a higher return by tying it to a stock market index.

Longevity annuity – the insurance company guarantees to provide you with a specified amount of lifelong income by age 85, let's say, deferring taxes and income until that age when you start taking money out.

Withdrawals are allowed in most contracts, with certain limitations. The typical contract allows for one annual withdrawal of 10 percent of the account value. If it exceeds that, the insurer charges a surrender fee on the excess, ranging from seven to 15 percent on a declining schedule.

Written into your deferred annuity contract is the option to turn your deferred annuity into an immediate annuity, essentially letting your earnings defer until you choose to turn the investment into a guaranteed stream of income.

The deferred annuity includes a death benefit component that ensures that the beneficiaries receive no less than the principal investment plus any gains in the account. Death benefit proceeds are taxable to the beneficiary as ordinary income.

As people worry more about running out of money during retirement, interest in deferred income annuities grows. These contracts give you a hedge against outliving your money. You give a lump sum payment to an insurance company, and you get a guaranteed stream of income for life. But any gain withdrawn prior to age 59 1/2 will be subject to a 10 percent penalty tax in addition to ordinary income taxes.

Beyond providing protection against outliving your money, deferred income annuities can give you peace of mind by reducing the stress of making your money last until you're 100, thus removing that uncomfortable feeling of uncertainty.

Annuities can be powerful estate planning tools, but they aren't right for everyone. Speak with a professional to see if annuities should be a part of your plan.

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